Antitrust regulators in the United States, Europe and Asia have recently looked at SEP issues in the contexts of merger control (Google-Motorola) and abuse (of a dominant market position). Some progress has been made, and more progress may be made in the months and years ahead, with respect to the undesirability of SEP-based injunctions (sales and import bans). But so far there are no signs of competition enforcers taking action against, or at least providing elaborate guidance relating to, excessive royalty demands. Maybe this will change, but antitrust authorities generally tend to leave royalty determinations -- including unreasonableness determinations -- to arbitration tribunals and courts.

Injunctions and excessive royalty demands (which companies like Samsung and Motorola make in order to have an excuse for the pursuit of injunctions) both harm competition and innovation, and consumers ultimately suffer from both types of conduct. Dealing with abusive injunction requests first is the right priority -- but the other problem must be addressed as well. Competition authorities are obviously more comfortable dealing with the (relatively speaking) straightforward, binary issue of injunctions than the potentially more labor-intensive task of assessing the market value of patent portfolios. The sheer number of patents declared essential to any given standard, let alone on the multiplicity of standards that complex products such as smartphones implement, is a deterrent. If Google owns X number of patents, there are Y number of other patents declared essential to the same standard and outside that standard the product may need a license to Z number of patents (some reading on other standards, some being non-SEPs), it may appear to be a Herculean task to collect the evidence and develop the theories for which a 2.25%-of-full-product-price royalty demand is outside the FRAND ballpark -- even though it wouldn't take a reasonable, knowledgeable and unbiased person a whole lot of number-crunching to see that no one could have a viable business in this industry if this royalty demand was extrapolated to all of the intellectual property needed to build a functional product. Google will obviously argue that its patents are far more valuable than the average patent declared essential to the same standard, even though its track record in court (only one out of ten SEP assertions against Apple has succeeded so far) suggests otherwise.

With the pursuit of injunctive relief becoming ever riskier for SEP abusers (though some are still trying this in the U.S. and testing the FTC's determination) and ever less likely to succeed, the primary playground for the gamesmanship of SEP abusers will be royalties (including damages for past use).

Google is now fighting hard against Judge Posner's position on damages for SEP infringement:

"[Judge Posner]'s rulings require [the appeals court]'s vacatur or reversal because they devalue essential patents as a manner of protecting fundamental research and development, upset the settled expectations of contributors to industry standards, and create disincentives going forward for others to participate in standards development that have served consumers well for decades."

This is a policy argument. Up to a certain point it's certainly true that more money in SEP holders' pockets means more of an incentive to invest in SEP-related R&D. But demands such as the ones Google's Motorola makes are way past the point at which there is any benefit to consumers. Instead, at this level consumers would be harmed. Harm has only been avoided because companies like Apple and Microsoft have refused to succumb to hold-up.

In its tireless efforts to talk up the value of SEPs, Google is pursuing a two-pronged strategy. On the one hand, it's trying to capture hold-up value in excess of the value of a "patent qua patent" that Judge Posner accurately argued is the FRAND value of an SEP. On the other hand, Google is arguing that SEP owners are generally entitled to high royalties because of the "fundamental research and development" they conduct.

Google's attempt to capture hold-up value is centered around the point in time at which a patent has the appropriate market value for FRAND purposes. Judge Posner's approach is ex ante: you get what your patent was worth before it was included in a standard because that's the instrinsic value of the innovation you've created. Even a weak patent (to which there are numerous alternatives) can suddenly become valuable if a standard prescribes only one way to encrypt a password or only one way to manage a hand-over between base stations of a cellular network. But the exclusion of alternatives through standardization creates monopolies that have nothing to do with the merit of the innovation involved. Google now says that Judge Posner erred because it's established Federal Circuit case law that "in the context of damages a reasonable royalty is to be determined based on a hypothetical negotiation as of the date infringement began". While Google concedes that Judge Posner's ex ante approach can somehow be part of the overall analysis, this paragraph leaves no doubt about Google's intent to capture hold-up value:

"The ex ante analysis required by the district court may be a relevant data point, but it cannot be the beginning and end of the damages analysis because it would value the patent years before infringement and would set the value before the technology had been tested in the market-place. If the patented technology (incorporated into the standard) is not successful, the technology is replaced or improved or the standard is abandoned. Evaluating the patent only before the standard is released pegs the patent's value years before the hypothetical negotiation, when it may have been worth considerably less than it became after the standard was implemented."

Contrary to what that paragraph suggests, the fact that a patented technique is not removed from a standard (or an entire standard abandoned) is primarily due to prohibitive switching costs. What Google's lawyers wrote almost sounds like industry standards are very much in flux during their life time, with the best being the enemy of the good. But that's not how it works in reality. If a patented technique prescribed by a standard is good enough, it will stay. A superior technique will be considered when the next standard is defined. If the next standard (such as the next version of the current one) needs to be backwards-compatible, the old SEP is still essential, even if it's no longer considered top of the crop. For example, the only cellular SEP that Google has so far been able to enforce against Apple anywhere in the world is a European patent (which the Mannheim Regional Court found Apple to infringe) declared essential to the GPRS standard, which is the data transmission standard that was built on top of the second-generation cellular standard, GSM. There are far better wireless data transmission protocols out there by now: 3G and 4G. Without a doubt those standards are also superior over GPRS with respect to the technique covered by Motorola's patent. But GPRS is still something Apple must implement in the German market.

Unlike Google I don't consider Judge Posner's ex ante approach to be inconsistent with the rule that reasonable royalties (as a type of damages) must be calculated as of the time when infringement began. The purpose of Judge Posner's "patent qua patent" formula is to separate the intrinsic value from the value of standard-setting (i.e., the exclusion of alternative techniques), which is necessary since the very act of standard-setting is an anticompetitive activity (if the major players in an industry agree on specifications that have an exclusionary effect with respect to previously-competing technologies) unless such overcompensation (based on monopoly power, not merits) is avoided, in which case the procompetitive aspects of standard-setting have a chance to outweigh the potential downside. Assuming that a patent was granted in 2003, its claimed technique incorporated into a standard in 2005, and Apple started implementing the standard in 2007, then the question at this point (with a view to damages) is what the patent was worth in 2007. But hold-up value must be subtracted. It wouldn't have been in issue in 2004 (pre-standardization), but it must be considered when determining the value the patent had in 2007. Maybe the patented technique was more valuable in its own right in 2007 than in 2004. But the FRAND value it had in 2007 must be based on a scenario in which competing solutions that were excluded by the standard were still available, and if those were similarly good, equally good, or perhaps even better, then the intrinsic value of the patent (without the benefit of being "the only game in town" due to what the standard prescribes) was not very high. In fact, the intrinsic value of that patent in 2007 would in most cases be lower than in 2004 because of additional alternatives that will have been published in the meantime.

In the hold-up context I'd also like to mention that Google is still defending the notion (expressed by a Motorola expert whose testimony Judge Posner threw out) that "in practice a single patent within a standards-essential patent portfolio, presumed valid and infringed, would command 'a disproportionate share of the overall portfolio rate,' '40 to 50 percent of the overall rate.'" Google's brief also notes that this expert "consulted Motorola's Director of Outbound Licensing, Brian Blasius, who stated that in his experience a single patent or a small number of patents within Motorola's standards-essential portfolio would command 'at least 50 percent' of the portfolio rate". The underlying logic of this is very much a hold-up concept: if a SEP holder enforced an injunction on only one patent that is truly essential, the defendant can no longer implement the standard. Or, as another Motorola expert put it in a different litigation, "it only takes one bullet to kill".

Just like some other SEP owners, Google makes the usual argument that the mere fact that a patented technique was incorporated into a standard is such a tremendous kind of recognition that the patent must have immeasurable value:

"[Judge Posner] failed to take into account that patents essential to a telecommunication standard are extremely valuable. Technology incorporated into standards is voted upon by industry participants, and represents the industry's best available solution for standards that are adopted worldwide."

In a perfectly meritocratic standard-setting universe this would be true, but it isn't in the world in which we live. Even in that parallel universe it's possible that something is chosen for a standard despite dozens, hundreds or even thousands of viable alternatives that are equally good or similarly good. For example, a standard-setting consortium can pick only one encryption algorithm for a given purpose. There may be countless other techniques out there, many thousands of which may be more or less equally good, but only one will make it into the standard. But the intrinsic value of that one is low because of the availability of so many alternatives, possibly also including some that were never patented (or the patents expired).

With respect to meritocracy, or the lack thereof, I'd like to point again (I've done it in a couple of previous posts) to a very interesting empirical study conducted by three European researchers (Rudi Bekkers, René Bongard and Alessandro Nuvolari) on "the determinants of essential patent claims in compatibility standards". Their key finding is that "the involvement in the standardization process is a stronger determinant than the technical value ('merit') of the patent". There may be more -- or at least there should be more -- research in this area. It's a very important point, and it's not that hard to imagine that standard-setting, with the major industry players sitting at a table, has a lot to do with bargaining and politics.

Google's (and other SEP holders') argument that SEPs are valuable is not only based on the stamp of approval that inclusion in a standard allegedly represents. They also argue that these teypes of techniques are very costly to develop:

"The telecommunications standard-setting process has fostered tremendous innovation through a series of ever-improving generations of mobile technology, but that is the result of equally tremendous amounts of investment by innovative companies that invent, share and license their research and development."

I recently had an informal conversation with a patent attorney who told me that he attaches greater value to SEPs than I do because he's drafted and prosecuted SEP applications and was generally impressed with the expensive research and development that went into those patents. I told him I didn't doubt that some very advanced, complex and, of course, costly technology is involved. But the way to value a patent is not to look at all of the components that it discloses, most of which will in this industry be previously-known (prior art). The correct approach is to look at the inventive step. And with the vast majority of SEPs that I've seen, the actual inventive contribution was rather underwhelming. Let me put it this way: no one doubts that the Mars Rover is technologically impressive and expensive. It's also capable of wireless communications, across a distance that is literally hundreds of millions greater than that of the average handset-to-base-station connection in a cellular network. If someone now claims a patent on a planetary rover equipped with a database of social network users and randomly picks one user each day who will get an electronic birthday card from another planet, that patent is still a trivial patent even though most of the disclosed technology is irrefutably non-trivial.

The aforementioned Motorola cellular SEP that was enforced against Apple in Germany is basically a countdown patent. The same countdown in any other kind of technology than a cellular network probably wouldn't have been patentable in the first place. I've seen various other SEPs that are about very simple communications protocols -- so simple that I believe they shouldn't even be patentable. Other cellular SEPs cover some bit-shifting operations that are efficient because of how the transceiver units work (for example, it's desirable to avoid certain sequences of signals).

Video codec SEPs often also appear impressive, but there are so many patents that have been declared essential to a standard such as H.264 that each patent can obviously cover only a small part of the overall technology.

Patent valuation will continue to be a complex field, and anything but an exact science. The Federal Circuit opinion on the cross-appeal of Judge Posner's ruling may provide some additional guidance.

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About Me

Florian Mueller is an app developer who used to be an award-winning intellectual property activist. His 30 years of software industry expertise span different market segments (games, education, productivity and infrastructure software), diverse business models, and technical and commercial areas of responsibility. In recent years, Florian advised a diversity of clients on the patent wars surrounding mobile devices, and on their economic and technical implications. (In order to avoid conflicts of interest, Florian does not hold or initiate transactions in any technology stocks or derivatives thereof, except that he is long AAPL.) He is now developing games for smartphones and tablet computers.